What happens to productivity will define our economic future

This article was first printed by the Times newspaper and has been reproduced here in full with permission.

George Osborne has many reasons to be cheerful as he prepares to sell his economic message to the nation. Growth is healthy, and better than in most of our competitors. Unemployment and inflation are both remarkably low. Most of the standard economic indicators look positive.

Yet things are not quite as positive as they might at first sight appear. And that’s not just because there remains a big budget deficit and much more austerity to come. Those facts largely reflect the lingering effects of the crisis and poor economic performance in 2011 and 2012. As well as dealing with the aftermath of those problems Mr Osborne, or his successor, will need to face a rather big current problem. We are getting the wrong kind of growth – growth with little increase in earnings or productivity. These two barometers of economic health both remain largely stuck. They are of course closely related.

We know about the lack of earnings growth. We all see it in our wage packets and the chancellor sees it in a lack of tax revenues. But what underlies this and sits alongside it is a dreadful productivity performance. On average private sector employees are producing no more per hour worked than six years ago. If normal rates of productivity growth had pertained we would be producing at least 15% more. That’s a huge loss. Recent figures suggest we have lost all the gains we made in 15 years prior to the crisis in catching up with countries like the US, Germany and France.

What happens next to productivity will define our economic performance over the next five years. In the end growing productivity is the key to our economic wellbeing. As the Nobel Laureate Paul Krugman once put it, productivity isn’t everything, but in the long run it is almost everything. Strong productivity growth will lead to higher earnings, higher living standards, and an easier job reducing the deficit. If productivity growth is weak, then we are in for some more tough years.

So why don’t we hear more about this from the politicians? Whatever they may say, they really can’t just legislate for higher earnings and lower prices. Those will come only as a result of a more productive and efficient economy.

Part of the problem of course is that this is a complex and multi-faceted issue. It is difficult to gain traction. But it really isn’t hopeless. Better public policy can help. Policy over the 30 years or so up to 2008 did play an active role in improving our performance – tax reform and privatisation in the 1980s, massive expansion of higher education through the 1990s and the strengthening of our competition regime through the 2000s all helped. We made real progress in catching up with the best. So what should Messrs Osborne and Balls be thinking about now?

Well we know what some of the big drivers of productivity are: education and skills, infrastructure, the competition regime, innovation, regulation and planning, and the tax regime. And actually we really do know in some of these cases what we would need to do to improve productivity – and therefore, in the longer run, growth and earnings.

So why don’t we just get on and do it? The answer is because there are trade-offs. Some real, some imagined. And that’s precisely why we should be spending much more of the political debate focussing on these issues.

Take infrastructure. A recent world economic forum report ranked the UK only 24th on the quality of its infrastructure. Yet infrastructure spending is always the first victim of austerity. That’s part of one trade-off. Do you cut spending on things that people value immediately – wages, services, pensions – or things that will produce benefits in the long-term?

Probably more important is the choice over what infrastructure to invest in. With a limited budget there are clearly numerous individual projects, cutting congestion on multiple parts of the road and rail system, which would have greater economic benefits than spending on grand individual projects like HS2.

Transport schemes can be costly not just in cash terms, but in environmental terms, and for those living close to the new routes. The same is true for new runways, and for all sorts of planning decisions. We could make the UK a more productive, richer economy. We have chosen not to, often because we weigh the obvious, negative effects on a minority more heavily than the dispersed positive effects on the great majority.

Similar things are true of the tax system. Improvements which make us all better off in the long run, but a few worse off in the short run, are hard to implement. The discussion doesn’t even recognise that taxes on firms are ultimately always paid by individuals in lower wages, higher prices, or lower returns on shares (held in pensions for example). Those dispersed costs are hard to factor in, but need to be. On the other hand any rationalisation of, for example, VAT and the (currently largely random) system of carbon taxes seems almost impossible because you can never design a compensation package which leaves nobody worse off. Integrating income tax and National Insurance Contributions is a long overdue reform that would rationalise the tax system, but it would take away from politicians a way of hiding tax rises, and again could leave a minority worse off. These same fears leave us with the inequitable and costly nonsense of a council tax system based on relative values from nearly 25 years ago.

There aren’t that many easy choices here. Many of them are about weighing the long run benefits of policy for all of us against very obvious immediate costs for a small number. As economists we can point out the trade-offs, and the importance of policies to promote productivity. The political process needs to get better at helping us make informed choices.